Mike Burkart, Denis Gromb, Holger M. Mueller and Fausto Panunzi

Legal investor protection and takeovers Article (Accepted version) (Refereed)

Original citation: Burkart, Mike, Gromb, Denis, Mueller, Holger M and Panunzi, Fausto (2014) Legal investor protection and takeovers. Journal of Finance, 69 (3). pp. 1129-1165. ISSN 0022-1082 DOI: 10.1111/jofi.12142 © 2014 the American Finance Association This version available at: http://eprints.lse.ac.uk/69540/ Available in LSE Research Online: February 2017 LSE has developed LSE Research Online so that users may access research output of the School. Copyright © and Moral Rights for the papers on this site are retained by the individual authors and/or other copyright owners. Users may download and/or print one copy of any article(s) in LSE Research Online to facilitate their private study or for non-commercial research. You may not engage in further distribution of the material or use it for any profit-making activities or any commercial gain. You may freely distribute the URL (http://eprints.lse.ac.uk) of the LSE Research Online website. This document is the author’s final accepted version of the journal article. There may be differences between this version and the published version. You are advised to consult the publisher’s version if you wish to cite from it.

Legal Investor Protection and Takeovers

MIKE BURKART, DENIS GROMB,

HOLGER M. MUELLER, and FAUSTO PANUNZI∗

ABSTRACT

This paper examines the role of legal investor protection for the efficiency of the market

for corporate control when bidders are financially constrained. In the model, stronger legal

investor protection increases bidders’ outside funding capacity. However, absent effective

bidding competition, this does not improve efficiency, as the bid price–and thus the bidder’s

need for funds–increases one-for-one with his pledgeable income. In contrast, under effective

competition for the target, the increased outside funding capacity improves efficiency by

making it less likely that more efficient but less wealthy bidders are outbid by less efficient

but wealthier rivals.

∗Burkart is with the Stockholm School of Economics, CEPR, ECGI, and FMG; Gromb is with INSEAD,

CEPR, and ECGI; Mueller is with the NYU Stern School of Business, NBER, CEPR, and ECGI; Panunzi

is with Università Bocconi, CEPR, and ECGI. We thank the Editor (Cam Harvey), the Associate Editor, an

anonymous referee, Augustin Landier and Richmond Mathews (our discussants), and seminar participants at

the NBER Corporate Finance Summer Institute, the AFA Meetings in Chicago, the 4th Paris Spring Corporate

Finance Conference, the 8th Annual Conference on Corporate Finance at Washington University (Olin), the FMG

25th Anniversary Conference at LSE, the IFN Conference on Entrepreneurship, Firm Growth and Ownership

Change in Vaxholm, University of Chicago (Booth), New York University (Stern), University of Utah (Eccles),

INSEAD, Polytechnique-CREST (joint seminar), X-CREST, IESEG, Stockholm School of Economics, Gothenburg

University, Bocconi University, University of Milano Bicocca, Einaudi Institute for Economics and Finance (EIEF)-

Consob (joint seminar), Luiss Guido Carli University, Duisenberg School of Finance, Tilburg University, IE

Business School, University of Lugano, University of Zurich, University of Piraeus, and Tsinghua University for

helpful comments. Financial support from the ESRC is gratefully acknowledged. Mike Burkart thanks the Jan

Wallander and Tom Hedelius foundations for financial support.

1

Building on the work of La Porta et al. (1997, 1998), several empirical studies have shown that

countries with stronger legal investor protection allocate resources more efficiently. For instance,

Wurgler (2000) shows that these countries increase investment more in growing industries–

and decrease it more in declining industries–relative to countries with weaker legal investor

protection. Likewise, McLean, Zhang, and Zhao (2010) show that firms in these countries

exhibit a higher sensitivity of investment to growth opportunities and, as a result, enjoy higher

total factor productivity growth and higher profitability.

An important resource allocation mechanism is the takeover market. In that market, both

assets and managerial talent are reallocated across firms and industries. Indeed, consistent with

the empirical evidence that countries with stronger legal investor protection allocate resources

more efficiently, Rossi and Volpin (2004) find that these countries also have more active takeover

markets.

Existing theory offers little guidance as to why the takeover outcome might be more efficient

in countries with stronger legal investor protection. This is for two reasons. First, takeover

models typically do not explicitly consider legal investor protection. Second, empirical research

suggests that legal investor protection matters primarily because it relaxes financing constraints

(e.g., La Porta et al., 1997; McLean, Zhang, and Zhao, 2010).1 However–and in stark contrast

to the “standard” corporate finance model of investment (e.g., Tirole, 2006)–existing takeover

models typically assume that bidders are financially unconstrained (e.g., Grossman and Hart,

1980, 1988; Shleifer and Vishny, 1986; Hirshleifer and Titman, 1990; Burkart, Gromb, and

Panunzi, 1998, 2000; Mueller and Panunzi, 2004).2

To address this issue, we incorporate both legal investor protection and financing constraints

into a standard takeover model à la Grossman and Hart (1980). In that model, no individual

target shareholder perceives himself as pivotal for the outcome of a tender offer, leading to

free-riding behavior. As a consequence, target shareholders tender only if the bid price reflects

1La Porta et al. (1997) show that countries with stronger legal investor protection have larger external capital

markets and more IPOs. McLean, Zhang, and Zhao (2010) show that firms in such countries exhibit both a lower

sensitivity of investment to cash flow–meaning they are less financially constrained–and a higher sensitivity of

either equity or debt issuance to q–meaning firms with better investment opportunities are better able to raise

outside funds.

2All these papers build on Grossman and Hart’s (1980) seminal analysis of the free-rider problem in takeovers.

While Chowdhry and Nanda (1993)–in a model that assumes no free-rider problem–and Mueller and Panunzi

(2004) examine the strategic role of debt financing in takeovers, neither of these two papers considers bidders’

financing constraints. In particular, this implies that–in contrast to the “standard” corporate finance model of

investment–bidders’ own resources are immaterial for efficiency.

2

the full post-takeover share value (Bradley, 1980; Grossman and Hart, 1980).3 However, if the

bidder cannot make a profit on tendered shares, value-increasing takeovers may not take place.

As Grossman and Hart argue, one way for the bidder to make a profit is by diverting corporate

resources as private benefits after gaining control. Private benefits extraction lowers the post-

takeover share value and thus the price which the bidder must offer target shareholders to induce

them to tender.

In our model, legal investor protection limits the ease with which the bidder, once in control,

can divert corporate resources as private benefits. This has two main implications. First, it

reduces the bidder’s profit from the takeover, thus making efficient takeovers less likely. Second,

it raises the post-takeover share value, thus increasing the bidder’s pledgeable income and, by

implication, his outside funding capacity. However, absent effective bidding competition, this

increased outside funding capacity does not relax the bidder’s budget constraint. As the bid

price increases in lockstep with the post-takeover share value–to induce target shareholders

to tender their shares–the bidder’s need for funds increases one-for-one with his pledgeable

income, thus offsetting any positive effect of legal investor protection on his outside funding

capacity.

The conclusion that legal investor protection does not relax the bidder’s budget constraint is

disconcerting. After all, empirical research suggests that one of the main effects of legal investor

protection is that it eases financing constraints. However, this conclusion follows naturally from

any setting in which the bid price adjusts in lockstep with the post-takeover share value and

thus with the bidder’s pledgeable income. Turning this result on its head, if the bid price did not

adjust in lockstep with the bidder’s pledgeable income, then the positive effect of legal investor

protection on the bidder’s outside funding capacity might have implications for efficiency.

While several factors might break this one-for-one relationship between the bid price and the

bidder’s pledgeable income, we focus here on one that we think is particularly relevant: bidding

competition, whereby bidders are forced to make offers exceeding the post-takeover share value.

3Rossi and Volpin (2004) provide empirical support for the free-rider hypothesis by showing that bid premia

in tender offers are higher than in alternative takeover modes. They conclude (p. 293): “We interpret the

finding on tender offers as evidence of the free-rider hypothesis: that is, the bidder in a tender offer needs to

pay a higher premium to induce shareholders to tender their shares.” In a recent empirical study, Bodnaruk et

al. (2011) provide more direct evidence in support of the free-rider hypothesis. Precisely, they show that: (i)

takeover premia are higher when the target’s share ownership is more widely dispersed, and (ii) firms with more

widely dispersed share ownership are less likely to become takeover targets. Both findings are consistent with

“finite-shareholder” versions of the free-rider model (e.g., Bagnoli and Lipman, 1988; Holmström and Nalebuff,

1992; Gromb, 1992).

3

Given that private benefits are not pledgeable, offers exceeding the post-takeover share value

must be partly funded out of the bidders’ own funds. Consequently, the takeover outcome may

not only depend on bidders’ willingness to pay–i.e., their valuations of the target–but also on

their ability to pay.

If bidders are arbitrarily wealthy, the takeover outcome depends exclusively on their will-

ingness to pay. This is the situation analyzed in much of the theory of takeovers. As the most

efficient bidder–i.e., the one who creates the most value–has the highest valuation of the tar-

get, he can always outbid less efficient rivals. Thus, absent financial constraints, the takeover

outcome is always efficient.

By contrast, if bidders are financially constrained, the takeover outcome may be inefficient.

To illustrate, suppose there are two bidders, bidder 1 and bidder 2 The target value is normalized

to zero. If bidder 1 gains control, the target value increases to 100 while if bidder 2 gains control,

it increases only to 90 Thus, bidder 1 is more efficient. Suppose next that both bidders can,

once in control, divert the same fraction of firm value, say, 30 percent, as private benefits. Hence,

if bidder 1 gains control, the post-takeover share value is 70 and his private benefits are 30

Similarly, if bidder 2 gains control, the post-takeover share value is 63 and his private benefits

are 27 Thus, bidder 1 is not only more efficient, but he can also raise more outside funds: Bidder

1’s outside funding capacity is 70 while bidder 2’s outside funding capacity is only 63 (Recall

that private benefits are not pledgeable.) And yet, bidder 2 may win the takeover contest.

Specifically, assume bidder 1 has no private wealth, while bidder 2 has private wealth of 8 In

this case, bidder 1 is able to pay 70 for the target, but bidder 2 is able to pay 71: He can raise

63 from outside investors and use 8 of his own wealth. Consequently, bidder 2 can outbid his

more efficient rival, bidder 1 and win the takeover contest.4

Accordingly, if bidders are financially constrained, the takeover outcome may not only de-

pend on their ability to create value but also on their private wealth. In particular, if the less

efficient bidder–i.e., the one who creates less value–is wealthier, the takeover outcome may be

inefficient. In this case, stronger legal investor protection may improve efficiency. To continue

with the above example, suppose that legal investor protection is now such that bidders can

divert only 10 percent of the firm value (versus 30 percent before). As a consequence, bidder 1’s

outside funding capacity is now 90 while bidder 2’s outside funding capacity is only 81 If the

4Bidder 1 is willing to pay up to 100 for the target, while bidder 2 is willing to pay up to 90. Hence, if the

bidders were financially unconstrained, bidder 1 would always win the takeover contest.

4

bidders’ private wealth is the same as before, this implies that bidder 1 can now pay 90 for the

target, while bidder 2 can only pay 81+ 8 = 89 Thus, bidder 1 can now outbid his less efficient

rival, bidder 2

We explore a number of implications of this argument, both normative and positive. First,

we examine the role of financing frictions, such as margin requirements (“haircuts”) and shadow

costs of internal funds. As we show, while margin requirements impair the efficiency of the

takeover outcome, shadow costs of internal funds improve it. Intuitively, margin requirements

reduce a bidder’s capacity to raise outside funds, which hurts more efficient (but less wealthy)

bidders relatively more. In contrast, shadow costs of internal funds hurt less efficient (but

wealthy) bidders relatively more by making it more costly for them to draw on their internal

funds. Our model predicts that the positive effect of legal investor protection on the takeover

outcome is weaker when margin requirements are high and internal funds command a high

shadow cost.

Our model also sheds new light on the “one share—one vote” rule, which stipulates that all

shares have equal voting rights. The leading argument in support of this rule is that it minimizes

the likelihood that more efficient bidders with low private benefits are outbid by less efficient

rivals with high private benefits (Grossman and Hart, 1988; Harris and Raviv, 1988). Naturally,

this argument does not apply in our model, as the most efficient bidder is also the one with

the highest private benefits. Nonetheless, a “one share—one vote” rule is optimal in our model,

because it minimizes the likelihood that more efficient but less wealthy bidders are outbid by

less efficient but wealthier rivals. Our model predicts that deviations from “one share—one vote”

are more detrimental to efficiency when legal investor protection is weak.

We also analyze situations in which a bidder seeks to acquire a majority of the target shares

from an incumbent blockholder. Effectively, the incumbent is like a rival bidder who is arbitrarily

wealthy: He can always “afford” the controlling block by simply refusing to sell it. Our model

predicts that efficient sales of control are more likely to succeed when legal investor protection

is strong and the incumbent’s controlling block is large. In a second step, we endogenize the

(optimal) size of the incumbent’s controlling block and find it to be larger when legal investor

protection is weak. This latter result is consistent with empirical evidence by La Porta et al.

(1998, 1999) showing that ownership is more concentrated in countries with weaker legal investor

protection.

5

We next examine issues related to cross-border M&A. In particular, we show that if bidders

from different countries compete for a target, those from countries with stronger legal investor

protection enjoy a strategic advantage. Our model predicts that takeover premia in cross-border

M&A deals are increasing in the quality of legal investor protection in the acquirer’s country,

consistent with empirical evidence by Bris and Cabolis (2008).

Finally, we show that firm-level governance–i.e., institutions that limit private benefits

extraction–can improve the efficiency of the takeover outcome. Indeed, if the cost of setting

up such institutions is sufficiently low, it may render both legal investor protection and bidders’

private wealth redundant. Our model predicts the strenght of firm-level governance to be de-

creasing in its own cost, the bidder’s wealth, and the strenght of legal investor protection, and

increasing in the value created by the bidder.

A recurrent theme in this paper is that legal investor protection helps efficient but less wealthy

bidders. Almeida and Wolfenzon (2006, AW) obtain a related result. In their model, a penniless

entrepreneur needs to fund a fixed setup cost to establish a firm. If the entrepreneur fails, the

firm is set up by a wealthy but less efficient family. Stronger legal investor protection increases

the entrepreneur’s outside funding capacity and–since the funding needs are fixed–relaxes his

budget constraint. This effect of legal investor protection also holds true in our model, but only

holding funding needs constant. However, central to our analysis is the feature that not only

funding capacity but also funding needs are endogenous to legal investor protection–i.e., legal

investor protection affects both sides of the budget constraint. This is true both in the single-

bidder case (because the bid price increases in lockstep with the bidder’s pledgeable income)

and in our competition model (because the rival’s maximum bid depends on legal investor

protection).

Essentially, AW’s model is akin to our single-bidder model but assuming a fixed bid price.

(In AW, the family does not really compete with the entrepreneur; it merely has a second pick

on the project if the entrepreneur fails to fund it.) Because of this difference, the two models

yield opposite results. In AW’s model, stronger legal investor protection improves efficiency

by making it more likely that the (more efficient) entrepreneur can finance the project’s fixed

cost. In contrast, in our single-bidder model, stronger legal investor protection does not improve

efficiency, as the bid price–the equivalent of the project’s cost–adjusts in lockstep. Indeed,

stronger legal investor protection makes efficient takeovers less likely by reducing the bidder’s

6

profit from the takeover.

The paper proceeds as follows. Section I lays out the basic model. Section II analyzes the

single-bidder case, while Section III examines that of “effective” bidding competition. Section

IV considers financing frictions, such as margin requirements (“haircuts”) and shadow costs of

internal funds, as well as the role of asset tangibility. Section V examines the optimal security-

voting structure, sales of controlling blocks, and cross-border M&A. Section VI studies the

interplay between legal investor protection and firm-level governance. Section VII concludes.

All remaining proofs are in the Appendix.

I. The Model

We consider a model of takeovers in which potential acquirers are financially constrained.

Suppose a firm (“target”) faces a potential acquirer (“bidder”). The target has a measure one

continuum of shares which are dispersed among many small shareholders. (Section V.B considers

the case in which the target has a controlling shareholder.) All shares have equal voting rights.

(Section V.A considers departures from “one share—one vote.”) Shareholders are homogeneous,

everybody is risk neutral, and there is no discounting.

The target value is normalized to zero. If the bidder gains control of the target, its value

increases to 0 To gain control, the bidder must make a tender offer to the target shareholders

that attracts at least a majority of the shares. (The bidder has no initial stake in the target.)

Target shareholders are atomistic in the sense that no individual shareholder perceives himself

as pivotal for the outcome of the tender offer. Tender offers are conditional on acquiring at least

a majority of the shares and unrestricted in the sense that the bidder must acquire any and all

shares beyond this threshold.5 If the tender offer is successful, the bidder incurs a monetary

execution cost 0 that cannot be imposed on either the target or its shareholders–that is,

unless the target is fully owned by the bidder, in which case the assumption becomes irrelevant.6

Even if a control transfer is efficient ( ) it may not take place. As Bradley (1980) and

Grossman and Hart (1980) show, if no individual target shareholder perceives himself as pivotal

5 Introducing restricted bids into our framework would neither affect the takeover outcome nor the payoffs to

the bidder and the target shareholders.

6With multiple bidders, it is important that the execution cost is only incurred by the winning bidder.

Otherwise, at least when the bidding outcome is deterministic, there would never be any bidding competition,

because the losing bidder would not break even.

7

for the outcome of the tender offer, efficient takeovers will not materialize unless the bidder

can extract private benefits of control. Accordingly, we assume that after gaining control, the

bidder can divert a fraction (1−) of the target value as private benefits, where ∈ £ 1¤. Forsimplicity, we assume that the extraction of private benefits involves no deadweight loss. Thus,

the bidder’s private benefits are (1−) while the security benefits accruing to all shareholdersare Importantly, the extraction of private benefits cannot be contracted upon. This implies

that the bidder cannot commit to a given level of private benefits, nor can he transfer or pledge

these benefits to third parties (e.g., investors).7 Instead, the legal environment–captured by

the parameter –effectively limits diversion, with larger values of corresponding to stronger

legal investor protection.

Our assumption that private benefits are not pledgeable, while security benefits are fully

pledgeable, simplifies the exposition but is stronger than necessary. Indeed, it suffices to assume

that private benefits are “less pledegable” than security benefits. This is plausible, especially

if private benefits come (partly) in the form of consumption (e.g., perks) or are obtained in

“semi-legal” ways.

In practice, there are different ways of how a controlling shareholder can extract private

benefits at the expense of other investors. For instance, he can sell target assets or output below

their market value to another company he owns. Alternatively, he can pay himself an artifi-

cially high salary or consume perks while declaring them as business expenses. Johnson et al.

(2000) describe how–even in countries like France, Belgium, and Italy–controlling sharehold-

ers can extract private benefits by transferring company resources to themselves (“tunneling”).

Bertrand, Mehta, and Mullainathan (2002), Bae, Kang, and Kim (2002), Atanasov (2005), and

Mironov (2012) provide further examples of tunneling from India, Korea, Bulgaria, and Russia,

respectively.8

To study the financing of takeovers, we assume that the bidder has internal funds ≥ 0In addition, the bidder can raise outside funds ≥ 0 from competitive investors. Since private

benefits are not pledgeable, the bidder’s outside funding capacity is limited by the value of his

7Our assumption that private benefits are not pledgeable rules out the possibility that the bidder can directly

pledge target assets as collateral even if he does not fully own the target, as discussed in Mueller and Panunzi

(2004). Such arrangements, which rely on second-step mergers between the target and a shell company owned by

the bidder, are not available in all countries. Even in the United States, their role has been diminished due to

the widespread adoption of (anti-)business combination laws.

8Barclay and Holderness (1989), Nenova (2003), and Dyck and Zingales (2004) are empirical studies docu-

menting the value of private benefits of control.

8

security benefits. We impose no restriction on the types of financial claims that the bidder can

issue against these security benefits.

The sequence of events is as follows.

In stage 1, the bidder decides whether to bid for the target. If he decides to bid, he can raise

outside funds in addition to his internal funds and make a take-it-or-leave-it, conditional,

unrestricted cash tender offer with bid price .

In stage 2, the target shareholders simultaneously and non-cooperatively decide whether to

tender their shares. The fraction of tendered shares is denoted by If 05 the takeover

fails. Conversely, if ≥ 05 the takeover succeeds, tendering shareholders receive a cash paymentequal to the bid price, and the bidder incurs the execution cost,

In stage 3, if the bidder gains control of the target, he diverts a fraction (1− ) of its value

as private benefits subject to the constraint ≥ imposed by the law.

To select among multiple equilibria, we apply the Pareto-dominance criterion, which selects

the equilibrium outcome with the highest payoff for the target shareholders (e.g., Grossman and

Hart, 1980; Burkart, Gromb, and Panunzi, 1998; Mueller and Panunzi, 2004). Among other

things, this implies that our focus on value-increasing takeovers is without any loss of generality.

Indeed, any equilibrium of the tendering subgame in which a value-decreasing takeover succeeds

is dominated by an equilibrium in which the takeover fails, where the latter equilibrium always

exists.9 Thus, Pareto dominance rules out what is, by all means, an implausible scenario, namely,

that target shareholders would tender at a bid price below the status quo value.10

The model is solved by backward induction. We first consider the bidder’s diversion deci-

sion followed by the target shareholders’ tendering decision and the bidder’s offer and financing

decisions. In general, a successful bid must win the target shareholders’ approval and match

any competing offer(s). We examine both the case in which shareholder approval is the bind-

ing constraint (“single-bidder case”) and the case in which outbidding of rivals is the binding

constraint (“bidding competition”).

9There is always a Nash equilibrium–in fact, a continuum of Nash equilibria–in which the takeover fails. If it

is anticipated that a majority of the target shareholders does not tender, any individual shareholder is indifferent

between tendering and not tendering, implying that failure can always be supported as an equilibrium outcome.

Note that while unconditional offers may avoid problems of multiple equilibria, they suffer from problems of

nonexistence of equilibrium (e.g., Bagnoli and Lipman, 1988).

10Grossman and Hart (1980, p. 47) also argue that bids below the status quo value are implausible, for exactly

the same reason, namely, because they fail whenever they are expected to fail. Naturally, a value-decreasing

takeover ( 0) may succeed if the bidder were to make an offer above the status quo value: 0. However,

making such an offer would violate the bidder’s participation constraint.

9

II. Single-Bidder Case

The single-bidder assumption does not literally rule out that other bidders are interested

in the target. It merely presumes that competition is “ineffective,” in the sense that no rival

can create nearly as much value as the bidder under consideration. By implication, shareholder

approval is then the binding constraint for a successful takeover.

Consider first stage 3, where the bidder must decide how much value to divert as private

benefits. If the bidder gains control, he chooses to maximize

− () + (1− ) (1)

where is the value of the security benefits associated with the bidder’s equity stake, ()

is the value of the outside claims issued against these security benefits, and (1 − ) is the

value of the bidder’s private benefits. Given that the extraction of private benefits involves no

deadweight loss, maximum diversion is always optimal: = .11 Thus, legal investor protection

imposes a binding constraint on diversion, and the value of the security benefits increases with

the quality of legal investor protection.

Consider next stage 2, where the target shareholders must decide whether to tender their

shares. Being atomistic, target shareholders tender only if the bid price equals or exceeds the

post-takeover value of the security benefits (Bradley, 1980; Grossman and Hart, 1980). Thus, a

successful tender offer must satisfy the “free-rider condition”

≥ (2)

If this condition holds with equality, target shareholders are indifferent between tendering and

not tendering. Without loss of generality, we break the indifference in favor of tendering.12 13

Thus, if the takeover succeeds, it succeeds with = 1

11Maximum diversion is strictly optimal if either 1 or () for some on a set of positive

measure. In contrast, the bidder is indifferent between diverting and not diverting if both = 1 and () ≤

for all i.e., if the value of the outside claims is unaffected by his diversion decision.

12See Grossman and Hart (1980, pp. 45-47). A common motivation for this assumption is that the bidder

could always break the indifference by raising the bid price infinitesimally.

13A small (technical) caveat: We break the indifference in favor of tendering only if the outcome is such that

the takeover succeeds. Hence, failure can still be supported as an equilibrium outcome.

10

Finally, consider stage 1, where the bidder must choose the offer price and secure financing

for the takeover. A successful offer must satisfy the free-rider condition (2) as well as two further

conditions. First, the offer must satisfy the bidder’s participation constraint. Given that = 1,

this constraint can be written as

− − ≥ 0 (3)

Note that the claims issued to outside investors and the funds provided by them do not appear

in the participation constraint. They cancel out as investors are competitive.

Second, the offer must satisfy the bidder’s budget constraint. Given that = 1, this con-

straint can be written as

+ ≥ + (4)

The left-hand side is the bidder’s total budget. Indeed, the bidder can pledge to outside investors

no more than the value of his security benefits, implying that his outside funding capacity is

limited to . The right-hand side represents the bidder’s need for funds, which includes both

the bid price and the execution cost, .

Lowering the bid price increases the value of the bidder’s objective function–i.e., the left-

hand side of (3)–while relaxing both his budget constraint and his participation constraint.

Therefore, the optimal bid is such that the free-rider condition holds with equality:

= (5)

Consequently, the bidder’s budget constraint becomes

≥ (6)

while his participation constraint becomes

(1− ) ≥ (7)

Importantly, the bidder’s budget constraint (6) does not depend on the strenght of legal

investor protection. In the original budget constraint (4)–i.e., before inserting the free-rider

condition–the bidder’s outside funding capacity increases with . Indeed, stronger legal in-

vestor protection limits the bidder’s ability to extract private benefits at the expense of other

11

investors. This increases his pledgeable income, thereby increasing his outside funding capacity.

However, once the free-rider condition is accounted for, the increased outside funding capacity

does not relax the bidder’s budget constraint, because the bid price–and thus the bidder’s need

for funds–increases in lockstep: = . Ultimately, the budget constraint is thus independent

of legal investor protection. Also, with all pledgeable value being captured by the target share-

holders, none of this value can be used to raise funds to cover the execution cost, . Accordingly,

that cost must be funded entirely out of the bidder’s internal funds: ≥ .

The more familiar participation constraint (7) reflects the fact that free-riding by the tar-

get shareholders limits the bidder’s profits to his private benefits net of the execution cost.

Stronger legal investor protection reduces the bidder’s private benefits, thereby tightening his

participation constraint.

Combining (6) and (7), we obtain the following result.

LEMMA 1: The bidder takes over the target if and only if

min{(1− )} ≥ (8)

To summarize, legal investor protection affects the takeover outcome in two ways. On the one

hand, stronger legal investor protection reduces the bidder’s profit, making efficient takeovers

less likely. On the other hand, stronger legal investor protection increases the bidder’s pledgeable

income and therefore his outside funding capacity. The latter effect is immaterial, however, as

the bid price–and thus the bidder’s need for funds–increases in lockstep with his pledgeable

income.

Let us briefly contrast our single-bidder model with the “standard” corporate finance model

of investment (e.g., Tirole, 2006, Chapters 3 and 4). In the standard model, increasing the

entrepreneur’s pledgeable income relaxes his budget constraint and improves efficiency. In con-

trast, here, increasing the bidder’s pledgeable income does not relax his constraint, because the

“investment cost” (i.e., the bid price) increases one-for-one with his pledgeable income due to

free-riding by the target shareholders.

We conclude this section by examining the effect of legal investor protection on the likelihood

that efficient takeovers succeed. In condition (8), the left-hand side decreases with Therefore,

as the quality of legal investor protection improves, it becomes less likely that the bidder acquires

12

the target.14

PROPOSITION 1: Absent effective competition for the target, stronger legal investor protection

makes it less likely that efficient takeovers succeed.

Note that, conditional on the takeover succeeding, target shareholders benefit from stronger

legal investor protection through a higher bid price. However, this has no implications for

efficiency: It merely constitutes a wealth transfer from the bidder to the target shareholders. In

contrast, the negative effect of legal investor protection on the bidder’s participation constraint

has implications for efficiency, as it makes it less likely that efficient takeovers succeed in the

first place.

III. Bidding Competition

As noted earlier, the single-bidder case does not literally rule out that there are multiple

bidders competing for the target. It merely presumes that such competition is “ineffective,” in

the sense that the binding constraint is shareholder approval–given by the free-rider condition

(5)–and not outbidding of rivals. By contrast, “effective” bidding competition implies that the

requirement to outbid rivals, rather than winning shareholder approval, determines the winning

bid price.

We consider two potential bidders, bidder 1 and bidder 2, competing to gain control of

the target. Bidder = 1 2 has internal funds . If bidder gains control, the target value

increases to 0 where 1 2 without any loss of generality. Regardless of which bidder

gains control, his ability to extract private benefits is limited by the same legal environment, .

(Section V.C examines the case in which bidders come from different legal environments.) The

takeover process is the same as in the single-bidder case, except that both bidders make their

offers simultaneously.

In stage 3, as before, the controlling bidder finds it optimal to divert a fraction (1 − ) of

the target value as private benefits. In stage 2, the target shareholders can be faced with up to

two offers. The case of a single offer is as before. The case of two offers is as follows.

14Here and elsewhere, we say that an event is more likely if it occurs for a larger set of parameter values.

13

LEMMA 2: In a Pareto-dominant equilibrium, the winning bid is the highest bid among those

satisfying ≥ , if any.

In stage 1, the bidders must decide whether to bid for the target. If so, they make their

offers simultaneously. Denote by b the highest offer which bidder is willing and able to make.That is, b is the highest value of satisfying the bidder’s participation constraint

≥ + (9)

and his budget constraint

+ ≥ + (10)

Accordingly, the highest offer which bidder is willing and able to make is

b = +min©(1− )

ª− (11)

The first term on the right-hand side represents the security benefits if bidder gains control.

The bidder is both willing and able to pay for these benefits as he can always pledge their value to

outside investors. The third term is the execution cost, . All else equal, it reduces the bidder’s

willingness to pay for the target. Finally, the second term is the minimum of the bidder’s private

benefits and his internal funds, which increase his willingness and ability, respectively, to pay

for the target.

LEMMA 3: Bidder 1 wins the takeover contest if and only if

min©(1− )1 1

ª ≥ (12)

and

1 ≥ min©(1− )2 2

ª− (1 − 2) (13)

Lemma 3 lays out two conditions for bidder 1 to win the takeover contest. The first condition,

(12), states that bidder 1 must be willing to incur and able to fund the execution cost. This

condition is the same as in the single-bidder case. It is independent of bidder 2’s presence or

his characteristics. If this condition does not hold, there is either no bidding competition or

14

no bidding at all.15 Consequently, to allow for bidding competition, we assume that is small

enough for condition (12) to hold.

ASSUMPTION 1: min©(1− )1 1

ª ≥

The second condition, (13), arises solely due to bidding competition. It determines under

what conditions bidder 1’s maximum offer, b1 exceeds bidder 2’s maximum offer, b2 As isshown, bidder 1’s internal funds, must exceed some minimum threshold. Accordingly, the

right-hand side of (13) captures the extent to which bidding competition tightens bidder 1’s

budget constraint. Importantly, the right-hand side decreases with . Hence, as the quality

of legal investor protection improves, competition has less of a tightening effect on bidder 1’s

budget, making it more likely that he can outbid his less efficient rival, bidder 2.

PROPOSITION 2: Under effective competition for the target, stronger legal investor protection

makes it more likely that efficient takeovers succeed.

When the more efficient bidder is wealthier (1 ≥ 2), condition (13) always holds, i.e.,

irrespective of the quality of legal investor protection. Indeed, bidder 1 not only has a higher

valuation of the target, but he also has a larger budget: He has both more internal funds

(1 ≥ 2) and a higher outside funding capacity (1 2). Thus, while bidder 2’s presence

may very well force bidder 1 to raise his bid, it will never exhaust his budget constraint. By

implication, bidder 1 always wins the takeover contest, and the quality of legal investor protection

is irrelevant for the takeover outcome.

Suppose now that the less efficient bidder is wealthier (1 2). When legal investor

protection is weak, the outcome is now more likely to be inefficient. As an illustration, consider

the extreme case in which investors enjoy no legal protection at all ( = 0). In that case, the two

bidders have no outside funding capacity and must rely entirely on their own funds to finance

their bids. While bidder 1 has a higher valuation of the target, his budget is tighter than bidder

2’s (because 1 2), possibly so tight as to prevent him from making an offer exceeding bidder

2’s. In that case, bidder 2 wins the takeover contest. As the quality of legal investor protection

improves, both bidders can pledge a larger fraction of the firm value to outside investors, which

increases both their budgets. However, because bidder 1 can create more value, his budget

15 If min(1− )1 1

= (1 − )1 both bidders’ participation constraints are violated as

min(1− )2 2

≤ (1− )2 (1− )1 In that case, there is no bidding at all.

15

increases more than bidder 2’s, making it more likely that he can outbid his less efficient rival.

Indeed, in the budget constraint (10), the left-hand side increases with at a rate of Given

that 1 2 an increase in therefore increases bidder 1’s budget more than it increases bidder

2’s budget.

Formally, it follows from condition (13) that if 1 ≥ min{2 2} the takeover outcome isalways efficient–i.e., regardless of the quality of legal investor protection. In all other cases,

there exists a critical value 0 0 such that the takeover outcome is efficient if and only if

≥ 0

We next examine whether–conditional on the takeover succeeding–target shareholders ben-

efit from stronger legal investor protection. To win the takeover contest, a bidder must not only

outbid his rival(s), but his offer must also satisfy the free-rider condition. Accordingly, the

winning bid is given by ∗ = maxnb o for 6= As the losing bidder’s maximum bid, b

is (weakly) increasing in this implies that the winning bid is also (weakly) increasing in

Intuitively, stronger legal investor protection affects the bid price through two channels. First,

it increases the value of the security benefits regardless of the winning bidder’s identity (

increases with ), thus forcing each bidder to raise his bid. Second, it increases both bidders’

outside funding capacity, thus allowing them to compete more fiercly for the target’s shares (bincreases weakly with ) For both reasons, stronger legal investor protection raises the winning

bid price. Consistent with this result, Rossi and Volpin (2004) find that takeover premia are

higher in countries with stronger legal investor protection.

Why is the effect of legal investor protection in the competition case different from that

in the single-bidder case? After all, in both cases, stronger legal investor protection improves

bidders’ outside funding capacity: Bidder ’s outside funding capacity, , increases with at

a rate of (cf., conditions (4) and (10)). However, in the single-bidder case, the bid price,

and hence the bidder’s need for funds, increases in lockstep–i.e., at the same rate–due to the

binding free-rider condition (5). Consequently, the bidder’s budget constraint is not relaxed.

By contrast, in the competition case, the winning bid ∗ is determined by the losing bidder’s

maximum offer b (that is, if competition is “effective”). Accordingly, bidder 1’s outside fundingcapacity increases with at a rate of 1 while his need for funds–in order to make a (winning)

bid equal to bidder 2’s maximum offer–increases only at a rate of 2 (cf., condition (11)).16

16The statement refers to the (relevant) case in which the biddders are financially constrained, so that (1 −) in condition (11). By contrast, if (1−) ≤ each bidder can bid up to his full valuation, implying

16

This relaxes bidder 1’s budget constraint and makes it more likely that he wins the takeover

contest, which is efficient. The opposite is true for bidder 2. His need for funds increases at a

rate of 1 while his outside funding capacity increases only at a rate of 2 This tightens bidder

2’s budget constraint and makes it less likely that he wins, which is again efficient.

IV. Financing Frictions

One of the contributions of this paper is to introduce financing constraints into a standard

takeover model. Doing so puts the focus on bidders’ budget constraints, with the implication that

they may frustrate efficient takeovers. This section studies financing frictions that may affect

bidders’ budgets and thereby the efficiency of the takeover outcome. Section IV.A considers

margin requirements that limit bidders’ outside funding capacity. Section IV.B analyzes shadow

costs of internal funds. Section IV.C explores the role of asset tangibility.

A. Margin Requirements

Margin requirements are common in lending. For instance, when lending cash to investors

for the purpose of buying securities, brokers typically require that investors put up some equity

of their own. Reasons for margin requirements are moral hazard and asymmetric information

on the part of borrowers, which can be mitigated if the borrower puts up some equity of his

own, and the aversion of lenders to possess collateral, which can be mitigated if the asset has an

equity buffer that prevents it from going “under water” too quickly. Consistent with investors’

reluctance to lend an amount equal to the full asset value, we assume that they provide funds

only up to (1 − ) where is the pledgeable asset value, as before, and is the fraction

which the borrower needs to contribute out of his own pocket (“haircut”).

A.1. Single-Bidder Case

The analysis of the single-bidder case is analogous to our basic model, with the exception

that the bidder’s budget constraint is replaced by

+ (1− ) ≥ + (14)

that the quality of legal investor protection is irrelevant.

17

Inserting the binding free-rider condition = into (14), we obtain

≥ + (15)

Note that unlike, e.g., firm-level governance, margin requirements affect the bidder’s budget

constraint but not the free-rider condition, as they do not affect the fundamental value of the

target if taken over by the bidder. Consequently, the budget constraint–after inserting the

binding free-rider condition–does not collapse into the familiar constraint ≥ from Section

II (cf., condition (6)).

In conjunction with the bidder’s participation constraint (7), this implies that we have the

following result.

LEMMA 4: The bidder takes over the target if and only if

min{(1− )− } ≥ (16)

By inspection, stronger legal investor protection impairs efficiency, for two reasons. First, like

in our basic single-bidder model, stronger legal investor protection reduces the bidder’s profits,

thereby tightening his participation constraint. Second, and this effect is new, stronger legal

investor protection tightens the bidder’s budget constraint: While it raises his need for funds by

–through the binding free-rider condition = –it increases his outside funding capacity

only by (1− ). As a consequence, the bidder faces a “funding gap” of , which he must

cover out of his internal funds.

In condition (16), the left-hand side decreases with both and Notably, the cross-

derivative with respect to and is negative, implying that legal investor protection and

margin requirements are complements: A higher value of one amplifies the negative effect of the

other (that is, on the likelihood that the takeover succeeds).

In sum, when the bidder’s outside funding capacity is impaired by margin requirements,

stronger legal investor protection tightens both his participation constraint and his budget con-

straint. That said, the qualitative implication of Proposition 1, namely, that stronger legal

investor protection makes efficient takeovers less likely, remains valid.

A.2. Bidding Competition

18

Again, the main change relative to the basic competition model is that bidder ’s budget

constraint is now

+ (1− ) ≥ + (17)

In conjunction with the participation constraint (9), this implies that the highest offer which

bidder is willing and able to make is

b = +min©(1− ) −

ª− (18)

Given Assumption 1, we can again derive conditions under which bidder 1’s maximum offer,b1 exceeds bidder 2’s maximum offer, b2LEMMA 5: Bidder 1 wins the takeover contest if and only if

1 ≥ min©(1− )2 2 − 2

ª+ 1 − (1 − 2) (19)

Note that the right-hand side is decreasing in and increasing in while the cross-derivative

of the right-hand side with respect to and is strictly positive.

PROPOSITION 3: Under effective competition for the target, the takeover outcome is more likely

to be efficient if legal investor protection is strong and margin requirements are low. Furthermore,

the positive effect of legal investor protection is weaker when margin requirements are high, while

the negative effect of margin requirements is stronger when legal investor protection is strong.

Intuitively, the right-hand side in (19) is increasing in because stronger margin require-

ments hurt bidder 1 relatively more than bidder 2 due to bidder 1’s larger outside funding

capacity. As for the cross-derivative, recall that stronger legal investor protection increases

bidder 1’s outside funding capacity more than bidder 2’s. This can be easily seen from (17),

where the difference ∆ = (1 − )(1 − 2) is increasing in That said, the rate of increase,

∆

0 is decreasing in , meaning the positive effect of legal investor protection–namely, to

increase bidder 1’s relative outside funding capacity–is weaker when margin requirements are

high. Likewise, we have that ∆

0 is lower when is high. While an increase in margin

requirements always hurts bidder 1 relatively more, it hurts him (relatively) the most when the

difference between his and bidder 2’s outside funding capacity is largest, i.e., when legal investor

protection is strong.

19

Finally, the winning bid, ∗ = maxnb o for 6= is (weakly) decreasing in Hence,

our model predicts that takeover premia are lower when margin requirements are high.

B. Shadow Costs of Internal Funds

Thus far we have assumed that bidders’ internal funds are excess cash or liquid funds.

However, in a world with financing frictions, firms will likely hold internal funds for a reason, e.g.,

to smooth out operational risks or fund investment projects that otherwise cannot be funded.

This, however, implies that internal funds ought to have a positive shadow value. Accordingly,

we assume that using ≤ units of internal funds entails a shadow cost of representing,

e.g., the forgone returns from alternative investment projects or the costs of liquidating less-

than-fully-liquid assets.

B.1. Single-Bidder Case

The analysis is analogous to our basic single-bidder model, except that the bidder’s partici-

pation constraint is now

− − − ≥ 0 (20)

Hence, using units of internal funds lowers the bidder’s payoff by . In contrast, the bidder’s

budget constraint depends only on his available internal funds, , not on the amount actually

used. Consequently, it is still given by (4) or–after inserting the binding free-rider condition–by

(6).

Inserting the binding free-rider condition into (20) yields

(1− ) − ≥ (21)

Since using internal funds involves a shadow cost, the bidder will first exhaust his outside funding

capacity. Hence, the amount of internal funds drawn on is = + − or–after inserting the

binding free-rider condition– = . As a result, the bidder’s participation constraint becomes

(1− ) ≥ (1 + ) (22)

As one might expect, an increase in the shadow costs of internal funds, tightens the bidder’s

participation constraint.

20

In conjunction with the bidder’s budget constraint (6), this yields the following result.

LEMMA 6: The bidder takes over the target if and only if

min

½(1− )

1 +

¾≥ (23)

As in our basic single-bidder model, legal investor protection has no effect on the bidder’s

budget constraint. However, it tightens his participation constraint, making efficient takeovers

less likely.

Of particular interest is that the cross-derivative of the left-hand side in (23) with respect

to and is positive. This has two implications. First, it implies that the negative effect of

legal investor protection on efficiency is weaker when is high. Intuitively, while legal investor

protection reduces the bidder’s private benefits, it also improves his outside funding capacity,

thereby reducing his need for internal funds, which in turn is more valuable when internal funds

command a high shadow value. Second, it implies that the negative effect of shadow costs

of internal funds is weaker when legal investor protection is strong. Intuitively, stronger legal

investor protection means that the bidder needs to use less internal funds, meaning a given

increase in involves a smaller reduction in his payoff.

B.2. Bidding Competition

Analogous to the single-bidder case, the main change relative to our basic competition model

is that bidder ’s participation constraint is now

− − − ≥ 0 (24)

Given that bidder fully exhausts his outside funding capacity before tapping into internal

funds, the amount of internal funds drawn on is = + − Hence, bidder ’s participationconstraint becomes

+(1− )

1 + − − ≥ 0 (25)

In conjunction with his budget constraint (10), this implies that the highest offer which bidder

21

is willing and able to make is

b = +min

½(1− )

1 +

¾− (26)

Again, we can determine the conditions under which bidder 1’s maximum offer, b1 exceedsbidder 2’s maximum offer, b2LEMMA 7: Bidder 1 wins the takeover contest if and only if

1 ≥ min½(1− )2

1 + 2

¾− (1 − 2) (27)

Note that the right-hand side is decreasing in and while the cross-derivative with respect

to and is strictly positive.

PROPOSITION 4: Under effective competition for the target, the takeover outcome is more

likely to be efficient if legal investor protection is strong and the shadow costs of internal funds

are high. Furthermore, the positive effect of legal investor protection is weaker when internal

funds command a high shadow cost, while the positive effect of shadow costs of internal internal

funds is weaker when legal investor protection is strong.

In our analysis, the main inefficiency in takeovers is that less efficient but wealthy bidders

may win the contest because i) limited pledgeability constrains bidders’ outside funding capacity,

and ii) their internal funds may allow them to overcome this “funding gap” and outbid more

efficient but less wealthy rivals. Consequently, any financing friction making it more difficult

or costly for bidders to raise outside funds–such as the margin requirements analyzed in the

previous section–must reduce efficiency. Conversely, any financing friction making it more

difficult, or costly, for bidders to draw on their internal funds must improve the efficiency of the

takeover outcome.

In this light, it becomes clear why high shadow costs of internal funds must improve efficiency:

They make it less likely that wealthy but inefficient bidders find it profitable to use their internal

funds to outbid less wealthy but more efficient rivals. Intuitively, this positive effect is more

pronounced when legal investor protection is weak, because this is precisely when internal funds

matter the most and the associated inefficiency is greatest. It is also intuitive why the positive

effect of legal investor protection is weaker when internal funds command a high shadow value:

22

If internal funds are expensive, then inefficient but wealthy bidders are less likely to win in the

first place, and institutions improving the relative outside funding capacity of more efficient

bidders, such as legal investor protection, are relatively less important.

Finally, the winning bid, ∗ = maxnb o for 6= is (weakly) decreasing in Thus, while

high shadow costs of internal funds are good for efficiency, they are bad for target shareholders

as they imply a lower bid premium.

C. Asset Tangibility

Some assets are more tangible than others, more difficult to divert, and their cash flows

are more readily verifiable. In a world with financing frictions, such assets are highly desir-

able, as they command a higher outside funding capacity. From an empirical perspective, the

implications of asset tangibility for financing constraints are an important topic (e.g., Almeida

and Campello, 2007). That being said, the economic forces through which asset tangibility and

legal investor protection affect the takeover outcome are similar. Accordingly, we shall confine

ourselves here to a brief verbal description of the results. The full analysis is provided in the

Internet Appendix.

To explore the effects of asset tangibility, we assume that a fraction of the target value

cannot be expropriated–irrespective of the quality of legal investor protection.17 In the single-

bidder case, an increase in asset tangibility tightens the bidder’s participation constraint but

has no effect on his budget constraint. Thus, akin to the role of legal investor protection, an

increase in asset tangibility makes it less likely that efficient takeovers succeed. By contrast,

in the competition model, stronger legal investor protection and high asset tangibility both

improve the efficiency of the takeover outcome. Importantly, the two are substitutes, meaning

the positive effect of asset tangibility is weaker when legal investor protection is strong, and vice

versa. Lastly, the model predicts that takeover premia are higher when asset tangibility is high.

V. Miscellaneous Extensions

Taking into account the interaction between legal investor protection and financing con-

straints also provides new insights into the optimal allocation of voting rights, the sale of con-

trolling blocks, and the role of legal investor protection for cross-border M&A. For brevity, we

17Almeida and Campello (2007) argue that asset tangibility is “a proxy for pledgeability” (p. 1430).

23

focus on the competition model, noting that the single-bidder model is straightforward to solve.

Given that the execution cost matters only in the single-bidder model, we set = 0 for simplicity.

A. “One Share—One Vote”

This section studies the implications of departures from “one share—one vote.” Suppose the

target has a dual-class share system: A fraction ∈ (0 1] of the shares have (equal) voting rights,while the remaining shares are non-voting. A “one share—one vote” structure corresponds to

= 1.

In stage 3, as before, the controlling bidder finds it optimal to divert a fraction (1− ) of thetarget value as private benefits. In stage 2, target shareholders of different voting classes may

face different bids, which they each must accept or reject. That is, we explicitly allow bidders

to make different bids for voting and non-voting shares. As it turns out, this problem can be

simplified.

LEMMA 8: Without loss of generality, we may assume that bidders make a bid only for voting

shares.

From the bidder’s perspective, it is immaterial whether or not he acquires non-voting shares:

They do not help him to gain control. Thus, the most he is willing to pay for these shares is

their “fundamental” value, 18 In contrast, as was shown in Section III, bidders may pay a

higher price for the voting shares to gain control of the target. Moreover, due to free-riding,

non-voting shareholders will tender only if the bid price is at least Accordingly, the only

bid price at which a transaction may occur is . At this price, however, both parties (bidder

and non-voting shareholders) are indifferent between trading and not trading. Thus, without

any loss of generality, we may assume that bidders do not make a bid for non-voting shares.

The tendering decision is the same as in our basic model. Hence, by Lemma 2, voting

shareholders tender to the highest bidder offering ≥ , if any. In stage 1, the bidders must

decide whether to bid for the target. Thus, we must again characterize the highest offer which

bidder is willing and able to make, b() i.e., the highest value of satisfying the bidder’sparticipation constraint

+ (1− ) ≥ (28)

18As is customary in the literature, we express bids in terms of a measure one of shares. Given that a fraction

(1−) of the shares are non-voting, this means the bidder is willing to pay up to (1−) for all of the non-votingshares.

24

and his budget constraint

+ ≥ (29)

In the participation constraint (28), is the value of the security benefits associated with

the voting shares, (1− ) are the bidder’s private benefits, and is the total payout to the

voting shareholders. In the budget constraint (29), the left-hand side represents the bidder’s

total budget, consisting of his internal funds, and his outside funding capacity, while

the right-hand side reflects his need for funds.

Accordingly, the highest offer which bidder is willing and able to make is

b = +1

·min©(1− )

ª (30)

This expression resembles (11), except that = 0 and that the second term is normalized by the

fraction of voting shares, Indeed, when not all shares carry a vote, the bidder’s willingness and

ability to pay, respectively, is spread across fewer shares. This increases the maximum offer he is

willing and able to make (for the voting shares). In particular, the bidder’s willingness to pay is

higher, because he can now obtain the same private benefits by acquiring fewer shares. Likewise,

his ability to pay is higher, because he can now use his private wealth for the acquisition of fewer

shares.19

LEMMA 9: Bidder 1 wins the takeover contest if and only if

1 ≥ min©(1− )2 2

ª− (1 − 2) (31)

By inspection, the right-hand side decreases with . Thus, the likelihood that bidder 1 wins

the takeover contest is highest under a “one share—one vote” structure.20

PROPOSITION 5: “One share—one vote” is socially optimal.

When the more efficient bidder is also wealthier (1 ≥ 2), condition (31) holds for any

value of That is, the takeover outcome is always efficient–irrespective of the fraction of

19Deviations from “one share—one vote” are equivalent to allowing for restricted bids where the biddders

compete for a fraction ≥ 05 of the shares and the winner is the bidder with the highest bid.20 In contrast, the security-voting structure (i.e., the value of ) is irrelevant in the single-bidder case, because

the bid price must equal the post-takeover value of the security benefits.

25

voting shares. The intuition is the same as in our basic model: Not only does bidder 1 have

a higher valuation of the target, but he also has a larger budget. Hence, bidder 1 can always

outbid his less efficient rival, bidder 2

Suppose now instead that the less efficient bidder is wealthier (1 2). If 1 is sufficiently

large, the takeover outcome is again efficient regardless of the fraction of voting shares. This

situation–i.e., when both bidders are financially unconstrained–is the situation analyzed in

much of the theory of takeovers.

However, if 1 is sufficiently small, the takeover outcome may be inefficient. Indeed, while

bidder 1 has a higher willingness to pay for the target, bidder 2’s ability to pay may be higher

due to his larger wealth. As an illustration, consider the (relevant) case where the bidders face

binding financing constraints, ≤ (1− ) By (30), this implies that the highest offer which

bidder is willing and able to make is

b = +

(32)

Hence, even though bidder 2 generates lower security benefits (2 1), his maximum offer

may be higher than bidder 1’s if 2 is sufficiently larger than 1 Moreover, when is small, a

smaller wealth difference, 2−1 is needed for bidder 2 to be able to outbid bidder 1. Intuitively,the effect of bidder wealth on the takeover outcome is larger when is small, because a given

wealth can be spread across fewer voting shares.

More formally, it follows from condition (31) that if 1 ≥ min©(1− )2 2

ª the takeover

outcome is efficient for any value of i.e., irrespective of the fraction of voting shares. By

contrast, if 1 min©(1− )2 2

ª − (1 − 2) the takeover outcome is inefficient for any

value of In all intermediate cases, there exists a critical value

b = min©(1− )2 2

ª−1

(1 − 2) (33)

such that the takeover outcome is efficient if and only if ≥ b By inspection, b decreases with Hence, departures from “one share—one vote” are more likely to lead to an inefficient takeover

outcome when legal investor protection is weak. (Conversely, weak legal investor protection is

more likely to lead to an inefficient takeover outcome when the fraction of voting shares, , is

small.)

26

COROLLARY 1: Deviations from “one share—one vote” are more likely to lead to an inefficient

takeover outcome when legal investor protection is weak.

Our result must be contrasted with that in Grossman and Hart (1988, GH) and Harris and

Raviv (1988, HR), who also find that “one share—one vote” is socially optimal. The economics

behind their result, however, is fundamentally different. In GH and HR, departures from “one

share—one vote” may allow bidders with low security benefits but high private benefits to win

against bidders with high security benefits but low private benefits, even if the former are less

efficient–i.e., even if they generate lower total benefits. In our model, this is not possible, as

security and private benefits are positively aligned. That is, our model assumes that bidders

can divert more value in absolute (i.e., dollar) terms from more valuable firms. In contrast, in

both GH and HR, bidders can divert more value in absolute terms from less valuable firms.

The converse is also true: The main inefficiency in our model–which is minimized under a

“one share—one vote” structure–does not arise in GH and HR. Recall that the main inefficiency

in our model is not that less efficient bidders may have a higher willingness to pay, as in GH and

HR, but rather that they may have a higher ability to pay. Hence, the sole reason why efficient

takeovers may not materialize in our model is because bidders are financially constrained. In

contrast, in both GH and HR, bidders are arbitrarily wealthy, so financing constraints play no

role.

B. Sales of Controlling Blocks

We next consider the case in which the target has a controlling shareholder (“incumbent”).

The incumbent owns a fraction ≥ 05 of the target shares and generates firm value 0 ≥ 0which is divided into security benefits 0 and private benefits (1 − )0. The target faces a

(single) potential acquirer (“bidder”). If the bidder gains control of the target, its value increases

to 1 0.

A transfer of control must be mutually beneficial, given that the incumbent can always block

the transfer at will. Accordingly, a control transfer may only occur if the bidder is willing and

able to compensate the incumbent for his controlling block. Consistent with the law and legal

practice in the United States, we assume that minority shareholders enjoy no rights in this

sale-of-control transaction. In particular, the bidder is under no obligation to extend his offer

to minority shareholders. In fact, he is under no obligation to make them any offer at all. This

27

rule, known as “market rule” (MR), is the prevailing rule in the United States. Given that it

imposes no obligation on the acquirer, “the MR is probably best described as the absence of a

rule, rather than a rule” (Schuster, 2013, p. 535).

Many other countries, including most European countries, use the “equal opportunity rule”

(EOR)–also known as “mandatory bid rule” (MBR)–which requires that the bidder makes an

offer to the minority shareholders on the same terms as his offer to the controlling blockholder.

At the end of this section, we offer a brief verbal discussion of what would change if the bidder

were subject to the EOR/MBR. A formal analysis is provided in the Internet Appendix.

In stage 3, as before, the bidder diverts a fraction (1 − ) of the target value as private

benefits. In stage 2, the incumbent and the minority shareholders may face different bids, which

they each must accept or reject. Note the analogy to Section V.A. There, we assumed without

loss of generality that bidders do not make a bid for non-voting shares. Likewise, here, the bidder

has nothing to gain from acquiring minority shares: They do not help him to gain control, and

the only price at which a transaction may occur is at their “fundamental” value, 1 making

everybody indifferent between trading and not trading. Analogous to Lemma 8, we can thus

assume without loss of generality that the bidder does not make a bid for the minority shares.

We must again characterize the highest offer which the bidder is willing and able to make,b1() i.e., the highest value of 1 satisfying his participation constraint1 + (1− )1 ≥ 1 (34)

and his budget constraint

1 + 1 ≥ 1 (35)

Conditions (34) and (35) are similar to (28) and (29), except that is replaced with

Accordingly, the highest offer which the bidder is willing and able to make is

b1 = 1 +1

·min©(1− )1 1

ª (36)

while the incumbent’s valuation of the controlling block is

0 = 0 + (1− )0 (37)

28

For a sale-of-control transaction to occur, the bidder’s maximum offer for the controlling block,

b1 must equal or exceed the incumbent’s valuation of the same, 0.21 Otherwise, there areno gains from trade.22

LEMMA 10: The bidder gains control of the target and only if

1 ≥ (1− )0 − (1 − 0) (38)

Condition (38) is similar to condition (31). The latter condition reflects the requirement

that bidder 1’s maximum offer for the block of voting shares, b1 must exceed bidder 2’smaximum offer, b2 Likewise, condition (38) states that the bidder’s maximum offer for the

controlling block, b1 must exceed the incumbent’s valuation, 0 The main difference is thatthe incumbent’s wealth does not enter in condition (38). As the incumbent already owns the

controlling block, his ability to pay is irrelevant. In a sense, the incumbent is like a rival bidder

who is arbitrarily wealthy.

By inspection, the right-hand side of (38) decreases with . Thus, the likelihood that the

sale of control takes place increases with the size of the controlling block.

PROPOSITION 6: Efficient sales of control are more likely to succeed when the controlling block

is large (as a fraction of the total equity value).

Recall that the incumbent’s wealth plays no role: He can always “afford” the controlling

block by simply refusing to sell it. Accordingly, whether or not the sale of control takes place

depends solely on the bidder’s wealth. If 1 is sufficiently large, the sale of control always takes

place–irrespective of the size of the controlling block. Thus, absent financial constraints, the

takeover outcome is always efficient.

In contrast, if the bidder is financially constrained, the sale of control may not take place.

Precisely, for the sale of control to succeed, the bidder must compensate the incumbent for his

security benefits, 0 and his private benefits, (1 − )0 To do so, the bidder can use his

internal funds, 1 and his outside funds, 1 Clearly, if 1 ≥ (1 − )0 the sale of control

21Recall that we express bids in terms of a measure one of shares. Thus, if the highest offer which the bidder

is willing and able to make is 1 his maximum offer for the controlling block is 122The sale will occur at some price ∈ [0 1] depending on the incumbent’s and bidder’s relative bargaining

powers. For our purposes, the value of is not important, as it does not affect efficiency.

29

always takes place. In contrast, if 1 (1 − )0 the bidder is unable to pay in full for

the incumbent’s private benefits out of his internal funds and must consequently tap his outside

funds, 1 However, since the bidder must also pay for the incumbent’s security benefits, 0

his “disposable” outside funds are only (1 − 0) If this is sufficient to cover the “funding

gap” of (1− )0 − 1 the sale of control will take place. Otherwise, it will fail. Importantly,

the bidder’s “disposable” outside funds are increasing in which explains Proposition 6.

Formally, it follows from condition (38) that if 1 ≥ (1 − )0 − 2(1 − 0) the sale of

control always takes place–irrespective of the size of the controlling block. By contrast, if

1 (1−)0−(1−0) the sale of control never takes place. In all intermediate cases, thereexists a critical value b ≥ 05 given by

b = (1− )0 −1

(1 − 0) (39)

such that the sale of control takes place if and only if ≥ b By inspection, b decreases with

Thus, efficient sales of control are more likely to occur when legal investor protection is strong.

COROLLARY 2: Stronger legal investor protection makes it more likely that efficient sales of

control succeed.

Bebchuk (1994) also finds that efficient sales of control may not take place, albeit for a

different reason. In his model, an incumbent with low security benefits but high private benefits

may not sell his controlling block to a potential acquirer with high security benefits but low

private benefits, even if the sale of control is efficient. In our model, this possibility cannot arise,

as security and private benefits are positively aligned. Instead, efficient sales of control may

fail in our model because bidders are financially constrained. In contrast, in Bebchuk’s model,

bidders are arbitrarily wealthy, so financing constraints play no role.

Thus far, we have (implicitly) assumed that the bidder makes an offer for the entire control-

ling block. We should point out that none of our results depend on this assumption. Given that

the likelihood of an efficient sale of control depends on the size of the controlling block, this may

at first glance seem surprising. However, it is easy to show that condition (38)–which is the

central condition characterizing when the bidder gains control of the target–remains unchanged

if we allow him to make a (restricted) offer for only a fraction of the controlling block.

To see this, suppose the bidder makes a bid 1 for a fraction 1 of the controlling

30

block, where ≥ 05 ensures that he acquires enough shares to gain control. We must againcharacterize the highest value of 1 satisfying the bidder’s participation constraint

1 + (1− )1 ≥ 1 (40)

and his budget constraint

1 + 1 ≥ 1 (41)

Hence, the highest offer which the bidder is willing and able to make is

b1 = 1 +1

·min©(1− )1 1

ª (42)

Comparing (42) with (36) illustrates that allowing the bidder to make a restricted bid raises

his maximum offer: b1 b1 Intuitively, the bidder is both willing and able to pay a higherprice as he can spread his private benefits and wealth, respectively, over fewer shares. However,

this offer is now only for a fraction of the incumbent’s shares. The remaining fraction, 1−

is valued at the post-takeover share value 1 b1 with the effect that the incumbent’s totalpayoff remains excactly the same as before:

b1 + (1− )1 = b1 (43)

Intuitively, the incumbent’s total payoff–i.e., the left-hand side in (43)–can be decomposed

into two parts: The security benefits associated with his controlling block, 1 and the control

premium paid by the bidder. The security benefits are evidently independent of But so is

the control premium. By (42), the control premium is equal to × 1·min©(1− )1 1

ª

which depends only on the bidder’s private benefits, (1− )1 and his wealth, 123

Having established that the incumbent’s payoff is independent of how many shares he sells–

as long as enough are sold to allow the bidder to gain control–the rest of the argument is

straightforward. In particular, as the incumbent’s payoff remains unchanged, the central con-

dition in Lemma 10 describing when the sale of control succeeds, (38), is also unchanged.24

23Recall that bids are expressed in terms of a measure one of shares. Thus, to obtain the control premium (in

dollars), one must multiply 1·min(1− )1 1

in (42) with the size of the block that is being traded,

24Precisely, the sale of control takes place if and only if

1 + (1− )1 ≥ 0 + (1− )0

31

Naturally, this implies that all results building on Lemma 10, such as Proposition 6 and Corol-

lary 2, also remain unchanged.

Returning to our main analysis, we now endogenize the size of the incumbent’s controlling

block. Suppose the incumbent is initially the firm’s sole owner. In the spirit of Zingales (1995),

he can retain a controlling block, ≥ 05 and sell the remaining shares, 1 − to dispersed

investors. At some future date, the firm is approached by a potential bidder, as described

above, and a control transfer may take place. As in Zingales’ analysis, everybody has rational

expectations about this future control transfer. For simplicity, we assume that the bidder has

full bargaining power vis-à-vis the incumbent, though all of our qualitative results remain valid

as long as he has some bargaining power.

We know that the control transfer succeeds if and only if condition (38) holds. In that

case, given that the bidder has full bargaining power, he acquires the controlling block at a

price equal to the incumbent’s valuation, (37). Moreover, when the incumbent sells shares to

dispersed investors, they rationally anticipate the control transfer and are thus willing to pay

up to (1− )1 for the minority stake. Overall, and as long as condition (38) holds, the

incumbent’s total payoff at the initial stage is therefore

0 + (1− )0 + (1− )1 (44)

Given that 1 0 the incumbent’s total payoff decreases with . On the other hand, condition

(38) becomes tighter as decreases. Consequently, the incumbent chooses the smallest value of

≥ 05 that is compatible with condition (38).

PROPOSITION 7: The incumbent’s optimal controlling block is

∗ = max½(1− )0 −1

(1 − 0) 05

¾ (45)

Zingales (1995) also models the incumbent’s choice of controlling block in anticipation of a

future control transfer, and he also assumes that the bidder is more efficient than the incumbent.

However, Zingales assumes that the bidder is arbitrarily wealthy. In our model, if the bidder

were sufficiently wealthy, the optimal controlling block would always be ∗ = 05 In contrast,

if the bidder is financially constrained–precisely, if 1 (1 − )0 − 2(1 − 0)–the optimal

Inserting 1 from (42) and going through the same steps as in the Proof of Lemma 3 yields (38).

32

controlling block is ∗ 05 By inspection, ∗ decreases with

COROLLARY 3: The optimal controlling block is larger when legal investor protection is weak.

This result is consistent with evidence by, e.g., La Porta et al. (1998, 1999), who find that

ownership is more concentrated in countries with weaker legal investor protection.

Let us conclude with a brief discussion of how our results might change if–instead of being

subject to the MR–the bidder were subject to the EOR/MBR. A formal analysis is provided

in the Internet Appendix.

Under the EOR/MBR, the bidder is obliged to make an offer to minority shareholders

on the same terms as his offer to the incumbent. Accordingly, if the bidder pays a control

premium to the incumbent, he must pay the same control premium also to minority shareholders.

This has two effects, both of which make efficient sale-of-control transactions less likely. First,

paying a control premium to minority shareholders reduces the bidder’s profits and tightens his

participation constraint. This effect–namely, that the EOR/MBR redistributes takeover gains

from the bidder to minority shareholders–is well known (e.g., Kahan, 1993; Bebchuk, 1994).

Second, and this effect is unique to our framework, any premium above the (pledgeable) security

benefits must be financed out of the bidder’s internal funds. Thus, if the bidder is forced to pay

a control premium also to minority shareholders, this tightens his budget constraint.

Besides the fact that efficient sale-of-control transactions are less likely to succeed, however,

nothing changes. In particular, as is shown in the Internet Appendix, all qualitative results from

this section–i.e., Proposition 6, Corollary 2, and Corollary 3–continue to hold if the bidder

were instead subject to the EOR/MBR.

C. Cross-Border M&A

This section extends our analysis to the case in which bidders come from different legal

environments. Without loss of generality, we assume that 1 2. That is, bidder 1 comes

from an environment with stronger legal investor protection than bidder 2. To isolate the effect

of legal investor protection on the takeover outcome, we assume that both bidders have the same

internal funds, and can create the same value,

In a typical cross-border M&A transaction, the target adopts the corporate governance

structures, accounting standards, and disclosure practices of the country of the acquirer (Rossi

and Volpin, 2004; Bris and Cabolis, 2008; Chari, Ouimet, and Tesar, 2009). Hence, if bidder

33

wins the takeover contest, his private benefits are (1−) while the security benefits accruing toall shareholders, including the bidder himself, are Note that, unlike in our previous analysis,

private and security benefits are now inversely related: While bidder 1 generates higher security

benefits, his private benefits are lower than bidder 2’s. Also, note that both bidders now generate

the same total (i.e., security plus private) benefits. From an efficiency standpoint, it is therefore

immaterial who wins the takeover contest. Thus, the question here is not whether efficient

takeovers take place, but rather under what conditions bidders from environments with stronger

legal investor protection can outbid their rivals from environments with weaker legal investor

protection.

In principle, minority shareholder protection at the target firm may become worse if the

acquirer comes from an environment with weaker legal investor protection.25 Empirically, this

case seems less relevant, however. In the vast majority of cross-border M&A deals, the acquirer

comes from a country with stronger, not weaker, legal investor protection (Rossi and Volpin,

2004; Bris and Cabolis, 2008; Chari, Ouimet, and Tesar, 2009; Erel, Liao, and Weisbach, 2012),

implying that “[o]n average, shareholder protection increases in the target company via the

cross-border deal” (Rossi and Volpin, 2004, p. 291). To avoid this issue altogether, we assume

that legal investor protection in the target’s home country, 0, is less than or equal to 2 In

the special case where 0 = 2 our model thus analyzes competition between a domestic bidder

(bidder 2) and a foreign bidder (bidder 1). In all other cases, it analyzes competition between

two foreign bidders.

The analysis is analogous to that in Section III, except that is bidder-specific, while both

and are identical across bidders. Accordingly, bidder ’s maximum offer is

b = +min©(1− )

ª (46)

PROPOSITION 8: If (1 − 2) the bidder from the country with stronger legal investor

protection wins the takeover contest. Otherwise, either of the two bidders may win the takeover

contest.

As both bidders create the same value, they have the same willingness to pay. Hence, the

25“The target almost always adopts the governance standards of the acquirers, whether good or bad” (Rossi

and Volpin, 2004, p. 300, italics added). Likewise, “the new law can be less protective than before, a type of legal

reform that is unheard of in the literature” (Bris and Cabolis, 2008, p. 606).

34

takeover outcome depends solely on their ability to pay. There are three cases.

If ≥ (1 − 2), neither bidder is financially constrained. As a result, both bidders can

make a bid up to their full valuation of the target, which implies either bidder may win the

takeover contest.

The second case, (1−2) ≥ (1−1) illustrates perhaps best the strategic role of legalinvestor protection in takeover contests. While both bidders create the same value, bidder

1 generates more security benefits. Bidder 1 has therefore a higher outside funding capacity,

allowing him to make a bid up to his full valuation, b1 = In contrast, bidder 2 can only make

a bid up to b2 = 2 + As a result, bidder 1 wins the takeover contest.

The third case, (1−1) is similar to the second, except that bidder 1 can no longer makea bid up to his full valuation. Consequently, both bidders can now only bid up to b = +

However, as bidder 1 generates more security benefits, he can still outbid his rival, bidder 2.

We may again ask whether–conditional on the takeover succeeding–target shareholders

benefit from stronger legal investor protection. In the first case, the winning bid is independent

of In the second and third case, the winning bid is ∗1 = max{b2 1}, which is (weakly)

increasing in the quality of legal investor protection in the acquirer’s country, 1 Consistent with

this result, Bris and Cabolis (2008) find that takeover premia in cross-border M&A deals are

higher when legal investor protection in the acquirer’s country is stronger than in the target’s.

Likewise, Rossi and Volpin (2004) find that takeover premia are higher in cross-border M&A

deals compared to domestic M&A deals, while the acquirer in a typical cross-border M&A deal

is usually from a country with stronger legal investor protection.

VI. Firm-Level Governance

So far, we have focused on the legal environment as the main source of investor protection.

However, firms can often improve on this minimum level. For instance, boards of directors or

audit committees may curb controlling shareholders’ self-serving behavior. In what follows, we

assume that potential bidders, by way of setting up such institutions, can credibly limit their

private benefits extraction, thus effectively converting private benefits into pledgeable security

benefits. However, doing so is costly. Monitors, such as auditors and independent directors,

require compensation for their activities. Such compensation is (realistically) paid out of the

firm’s own pocket. Accordingly, we assume that converting units of private benefits into

35

security benefits reduces firm value by , where 0 1. Security benefits are thus given

by ( − ) + while private benefits amount to (1− )( − )− Starting from the level

of private benefits associated with the level of legal investor protection, (1 − ) this implies

that the maximum amount of private benefits that can be converted is ≤ (1− )( − ) or,

equivalently, ≤ (1−)1+(1−)

A. Single-Bidder Case

Stages 2 and 3 are analogous to our basic model. In particular, in stage 3, we have maximum

dispersion, = , while in stage 2 a successful tender offer must satisfy the free-rider condition

≥ ( − ) + (47)

Next, consider stage 1, where the bidder must choose the offer price In addition to satisfying

the free-rider condition (47), a successful tender offer must also satisfy the bidder’s participation

constraint

− − − ≥ 0 (48)

and his budget constraint

+ ( − ) + ≥ + (49)

As usual, the optimal bid in the single-bidder case is such that the free-rider condition (47)

holds with equality. Hence, the bidder’s budget constraint becomes

≥ (50)

and his participation constraints becomes

(1− )( − )− ≥ (51)

The budget constraint (50) is identical to that in our basic model and is independent of legal

investor protection but also of firm-level governance. Intuitively, once the free-rider condition

is accounted for, the additional outside funding capacity due to firm-level governance does not

relax the bidder’s budget constraint, as the bid price–and thus the bidder’s need for funds–

increases in lockstep: = (−)+ Consequently, the only effect of firm-level governance is

36

that it reduces the bidder’s private benefits, thus tightening his participation constraint. Unlike

in the basic model, however, this is now for two reasons. For one, there is the direct, marginal

reduction in private benefits of . In addition, however, there is also the inframarginal reduction

of (1−) arising from the fact that the cost of firm-level governance is paid out of the firm’s

pocket.

Given that firm-level governance has no benefits, but only costs, the bidder optimally sets

∗ = 0 As a result, the remaining analysis of the single-bidder case is isomorphic to our basic

single-bidder model.

B. Bidding Competition

Firm-level governance does matter under effective competition among bidders. Stages 2 and

3 are analogous to our basic competition model, except that the free-rider condition in Lemma

2 is replaced by the requirement that ≥ ( − ) +

Consider next stage 1, and denote by b the highest offer which bidder is willing and ableto make. That is, b is the highest value of satisfying the bidder’s participation constraint

− − − ≥ 0 (52)

and his budget constraint

( − ) + + ≥ + (53)

Hence, converting private benefits into security benefits ( 0) relaxes the bidder’s budget

constraint but tightens his participation constraint.

Given (52) and (53), the highest offer which bidder is willing and able to make is

b = +min©(1− ) − + (1− )

ª− (54)

The first term in brackets is decreasing in while the second term is increasing in Accord-

ingly, if the binding constraint is the bidder’s participation constraint (i.e., (1− ) ), his

maximum offer is given by b = −− which implies he optimally sets ∗ = 0 In contrast,

if the binding constraint is the bidder’s budget constraint (i.e., (1 − ) ≥ ), his maximum

offer is given by b = ++ (1−)− As this expression is increasing in the bidder

37

optimally raises until the second term in brackets equals the first.26 Formally, this implies

that ∗ is given by

(1− ) − ∗ = + ∗ (1− )

LEMMA 11: Bidder i ’s optimal choice of firm-level governance is given by

∗ =

⎧⎨⎩ 0 if (1− )

(1−)−

1+(1−) if (1− ) ≥

(55)

Some comparative statics are of interest. Specifically, we have from (55) that∗≤ 0

∗≤ 0 ∗

≤ 0 and ∗

≥ 0 Moreover, the case where (1 − ) ≥ becomes more likely

when and are small and when is large.

COROLLARY 4: Bidder i ’s optimal choice of firm-level governance is decreasing in the cost of

governance, the bidder’s wealth, and the strenght of legal investor protection, and is increasing

in the (gross) firm value created by the bidder.

That ∗ is decreasing in the cost of governance is intuitive. Also intuitive is that it is

decreasing in the bidder’s wealth. After all, the only purpose of firm-level governance in our

model is that it relaxes the bidder’s budget constraint. Indeed, if the bidder is sufficiently

wealthy ( (1 − )), his optimal choice of firm-level governance is ∗ = 0. Likewise, it is

intuitive that ∗ is decreasing in the strenght of legal investor protection. Indeed, legal investor

protection and firm-level governance serve the same purpose in our model, but the latter is more

costly. Finally, that ∗ is increasing in firm value illustrates why empirical correlations between

firm-level governance and firm value should be interpreted with caution. Indeed, in our model,

the causality goes the other way: Higher firm value implies that more private benefits can be

converted into pledgeable security benefits by way of firm-level governance.

Inserting bidder ’s optimal choice of firm-level governance, (55), into his maximum offer

function, (54), we obtain the highest offer which he is willing and able to make:

b = min½ +

1 + (1− )

¾− (56)

26 If the bidder increased beyond this point, the binding constraint in (54) would become again the partici-

pation constraint, implying the bidder’s maximum offer would be decreasing in Accordingly, “optimal” means

that ∗ is the choice of firm-level governance that maximizes bidder ’s likelihood of winning the takeover contest.

38

where b = − if and only if (1− ) ≤

Accordingly, if bidder is sufficiently wealthy ( ≥ ) he is both willing and able to make

a bid up to his full valuation of the target, − regardless of the quality of legal investor

protection. Moreover, in this case, we know from (55) that his optimal choice of firm-level

governance is ∗ = 0 In contrast, if there exists a critical value 0= −

such that

bidder ’s maximum offer is less than his full valuation if 0and equal to his full valuation if

≥ 0 In the former case, bidder ’s maximum offer is increasing in while his optimal choice

of firm-level governance is ∗ 0 with∗

0 and ∗ → 0 as → 0

We can again compare under what conditions bidder 1’s maximum offer, b1 exceeds bidder2’s maximum offer, b2LEMMA 12: Bidder 1 wins the takeover contest if and only if

1 ≥ min©(1− )2 2

ª− (1 − 2)

(57)

As in our basic competition model, stronger legal investor protection promotes efficient

takeover outcomes. Formally, if 1 ≥ min{2 2} − (1−2)

the takeover outcome is efficient

for any value of In all other cases, there exists a critical value 00 0 such that the outcome

is efficient if and only if ≥ 00

These benefits of legal investor protection notwithstanding, allowing for firm-level governance

may render legal investor protection redundant. To illustrate, consider the extreme case in which

the costs of firm-level governance approach zero ( → 0) In this case, condition (57) implies

that bidder 1 always wins the takeover contest, regardless of his private wealth or the quality

of legal investor protection. Intuitively, the role of legal investor protection in our model is to

provide bidders with pledgeable income, while that of private wealth is to make up for shortfalls

in bidders’ pledgeable income. However, if bidders can costlessly convert private benefits into

pledgeable security benefits, neither legal investor protection nor the bidders’ private wealth

matter for efficiency.

More generally, allowing for firm-level governance, even if costly, makes it more likely that

the target goes to the bidder who creates the most value. This is because higher-value bidders

have more private benefits that can be converted into security benefits, which gives their outside

funding capacity a greater boost.

39

PROPOSITION 9: Under effective competition for the target, firm-level governance may improve

the efficiency of the takeover outcome. The improvement is larger when legal investor protection

is weak, when the costs of firm-level governance are low, and when the difference in firm values

created by the bidders is large.

As an illustration of how firm-level governance can improve efficiency, suppose that1 2

2 (implying 1 1)27 By condition (11), this implies that, without firm-level governance,

bidder 1’s maximum offer is b1 = 1 +min©(1− )1 1

ª− while bidder 2’s is b2 = 2 −

Thus, by Lemma 3, bidder 1 loses the takeover contest if 2−11

Suppose now we allow firm-level governance, thus allowing bidders to convert private benefits

into pledgeable security benefits. By Lemma 11, bidder 2 optimally sets ∗2 = 0 implying his

maximum offer remains unchanged. In contrast, bidder 1 sets ∗1 = 0 for all 1−11

but

∗1 =(1−)1−11+(1−) 0 for all ≤ 1−1

1 In the latter case, bidder 1’s maximum offer increases tob1 = 1+1

1+(1−) − (see equation (56)).

The upward shift of bidder 1’s maximum offer function makes it more likely that bidder 1

succeeds, thereby improving efficiency. While the takeover outcome was, and still is, efficient

if ≥ 2−11

, it was previously–i.e., without firm-level governance–inefficient if 2−11

.

Introducing firm-level governance narrows the range of −values for which the takeover outcomeis inefficient. Precisely, by Lemma 12, bidder 1 loses the takeover contest if

2−1+(2−1)2

which is less than the respective threshold value without firm-level governance, 2−11

. In fact,

if the cost of firm-level governance is sufficiently small ( ≤ 1−22−1 ), bidder 1 always wins,

irrespective of the quality of legal investor protection.

VII. Conclusion

This paper studies the effect of legal investor protection on the efficiency of the market for

corporate control. Stronger legal investor protection limits the ease with which the bidder, once

in control, can divert corporate resources as private benefits. This has two main implications.

First, it reduces the bidder’s profit, thus making efficient takeovers less likely. Second, it increases

the bidder’s pledgeable income and thus his outside funding capacity. However, absent effective

27Any (non-trivial) claims made in this example are proven in Appendix B.

40

bidding competition, this increased outside funding capacity does not relax the bidder’s budget

constraint, as the bid price increases in lockstep with his pledgeable income.

In contrast, under effective bidding competition, stronger legal investor protection–and the

associated increase in the bidders’ outside funding capacity–may improve the efficiency of the

takeover outcome. In particular, by boosting bidders’ ability to raise outside funds against the

value which they create, stronger legal investor protection makes it less likely that more efficient

but less wealthy bidders are outbid by less efficient but wealthier rivals.

The presence of a binding budget constraint also provides a novel rationale for the “one

share—one vote” rule. In our model, such a rule is socially optimal, as it maximizes the likelihood

that the takeover outcome is determined by bidders’ ability to create value rather than by their

budget constraints. In addition, our model provides novel empirical implications relating the

takeover outcome to, firm-level governance, margin requirements, asset tangibility, and block

ownership, to name just a few.

Appendix A: Proofs

Proof of Lemma 2 : For a bid to succeed in equilibrium, it must satisfy the free-rider condition,

≥ . If no bid satisfies this condition, the only equilibrium outcome is that the takeover does

not place. Suppose therefore that a bid satisfies ≥ . If a target shareholder anticipates

the bid to succeed, tendering his shares is (at least) a weakly dominant strategy. Hence, an

equilibrium exists in which a bid succeeds if and only if ≥ . Among all equilibria, the

target shareholders’ payoff is highest in those in which the highest bid succeeds. Q.E.D.

Proof of Lemma 3 : For a bid to succeed under competition, it would a fortiori also have to

succeed absent competition. By Lemma 1, this is true if and only if condition (12) holds.

Moreover, in a Pareto-dominant equilibrium, bidder 1 wins the takeover contest only if b1 ≥ b2.Using expression (11), this can be written as

1 +min©(1− )1 1

ª− ≥ 2 +min©(1− )2 2

ª− (58)

or

min©(1− )1 1

ª ≥ min©(1− )2 2ª− (1 − 2) (59)

41

If (1− )1 ≤ 1 this condition always holds because

(1− )1 (1− )2 − (1 − 2) ≥ min©(1− )2 2

ª− (1 − 2) (60)

Hence, condition (59) can be written as condition (13). Q.E.D.

Proof of Lemma 8 : Suppose bidder bids for voting shares and 0 for non-voting shares.

Who wins the takeover contest is determined solely by the bids for voting shares. Hence, in a

Pareto-dominant equilibrium (for the voting shareholders), the winning bid is the highest among

those satisfying ≥ if any. If bidder fails to gain control, his bid for non-voting shares

is irrelevant. (Bids for non-voting shares are conditional upon gaining control.) Conversely, if

bidder gains control, non-voting shareholders tender only if 0 ≥ . In this case, the winning

bidder’s payoff is

¡ −

¢+ (1− )

¡ − 0

¢+¡1−

¢ (61)

Given the requirement that 0 ≥ expression (61) is maximized for 0 = in which case

it becomes

¡ −

¢+¡1−

¢ (62)

which is the same as if bidder did not bid for non-voting shares. Consequently, bidder is

indifferent between bidding and not bidding for non-voting shares: He makes zero profit on these

shares, and they do not help him gain control. Q.E.D.

Proof of Lemma 10 : The proof is analogous to that of Lemma 3 with = 0 and expression (11)

replaced by (36) for the bidder and

b0 = 0 +1

· (1− )0 (63)

for the incumbent, respectively. Q.E.D.

Proof of Proposition 9 : The result follows from comparing condition (57) with the corresponding

requirement from Section III, condition (13), noting that

1 − 2

1 − 2 (1 − 2) (64)

42

for all 1 and 1 and that ( 1− )(1 − 2) is decreasing in and and increasing in

1 − 2 Q.E.D.

Appendix B: Example Following Proposition 9

Recall that 1 2 2 (implying that 1 1) The first unproven claim is that raising

bidder 1’s maximum offer from b1 = 1+1− to b1 = 1+11+(1−) − for all ≤ 1−1

1narrows

the range of −values where the takeover outcome is inefficient, i.e., where bidder 1 loses. Giventhat bidder 2’s maximum offer was, and still is, b2 = 2− the takeover outcome was previously(i.e., without firm-level governance) inefficient if 1 + 1 2 or 2−1

1 In contrast, it is

now inefficient if 1+11+(1−) 2 or

2−1+(2−1)2

To prove that2−1+(2−1)

2 2−1

1 it

suffices to show that 1+11+(1−) lies strictly above 1 + 1 for all 1−1

1 To see this, note

that 1+11+(1−) = 1 + 1 at =

1−11

with derivative

1+11+(1−)

¯=

1−11

= 1 1 That

1+11+(1−) is strictly increasing and convex in completes the proof.

The second unproven claim is that if ≤ 1−22−1 bidder 1 wins the takeover contest for all

To see this, recall that b1 = 1+11+(1−) − is strictly increasing in Hence, we have thatb1 ≥ b2 = 2 − for all if 1+1

1+≥ 2 or ≤ 1−2

2−1 Indeed, if1+12≥ 2 we have that

1−22−1 ≥ 1 In this latter case, bidder 1 wins the takeover contest for all even as → 1

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